Educational Articles

Mathematically speaking, free cash flow is net income plus depreciation, minus the total of dividends, capital expenditures, required debt repayments, and any other scheduled cash outlays. It’s basically a measure of how much hard cash a company generated in a given period after paying for its regular business expenses and growth initiatives. It is a good gauge of how well management is performing for its shareholders.

Some investors prefer free cash flow over earnings because they believe that earnings, which are largely an accounting figure, can be manipulated more easily than hard cash. Also, in some cases, earnings get distorted unintentionally by accounting principles. Depreciation is an excellent example of the latter, since the measure inherently represents money that has already been spent and has little-to-no impact on a company’s cash flow, but often has a major impact on earnings.

Of course, free cash flow isn’t the only metric one should consider when evaluating an investment opportunity, but it can quickly weed out companies that simply don’t measure up. To help investors find companies that have a solid history of generating healthy amounts of free cash flow, Value Line produces a weekly screen that highlights this metric and appears in the Index section of every issue of The Value Line Investment Survey.

Labeled “Biggest ‘Free Flow’ Cash Generators”, the screen lists the top 100 companies of the roughly 1,700 in The Value Line Investment Survey based on free cash flow generation over a trailing five-year period. The long time frame is used to ensure that companies with solid histories of creating cash flow are brought to the fore, weeding out operators that experience a temporary boost to their cash flow generation because of short-term or one-time events.

For this screen, we chose to only consider companies in the Medical Supply Industry (invasive and non-invasive, see list below). Of the seven medical supply companies that made the list of top cash generators in the Value Line universe, we have selected Thoratec Corporation (THOR) for further review.

Thoratec Corporation

Thoratec Corporation designs and manufactures mechanical circulatory support products to treat advanced heart failure (HF). This disease occurs when degeneration of the heart muscle reduces the pumping power of the heart, causing it to become too weak to pump blood at a level sufficient to meet the body's demands. Thoratec’s devices supplement the pumping function of the heart in patients with heart failure, a condition that 6.6 million people in the U.S. currently suffer from according to the American Heart Association.

The company’s primary product line is called HeartMate. Heartmate products are implantable, electrically powered, continuous flow, left ventricular assist devices (LVADs) designed to improve survival and quality of life. HeartMate II is the most widely used LVAD available today.

Despite attempts to manage HF through drug therapy, the only curative treatment for late stages of the disease is heart transplantation. The number of donor hearts available each year can meet the needs of only a small number of patients. Three of Thoratec’s devices are “bridge to heart transplant” (BTT) certified and 122 of its 167 heart centers are “destination therapy” (DT) certified. These certifications show that Thoratec’s solutions have been found to effectively support a person's circulatory system while they wait for a transplant. Approximately 40%-50% of the patients on the waiting list for a heart transplant in the U.S. receive an LVAD. The percentage of bridge-to-transplant patients should increase as surgeons' level of comfort with the technology rises, particularly for longer-term support cases.

Thoratec began 2013 with disappointing results. Revenues fell 7% year over year, largely due to a difficult comparison and greater competition from HeartWare International (HTWR), which recently gained BTT approval in the U.S. Although heart pump prices increased, volumes didn’t, and solid non-pump revenues were not enough to offset this. Considering there are usually less than 1,000 implants done in the U.S. each quarter, lumpy volumes from one quarter to the next are not uncommon.

Despite the increased competition, Thoratec left its 2013 guidance intact, which demonstrates its confidence that results will pick up for the remainder of the year. The company does face easier comparisons in the second and third quarters. Further, recent trials of HeartWare’s HVAD product showed the frequency of stroke to be around 8% more than Thoratec’s HeartMate II. Still, buyers of these devices may wish to have a second option to reduce the bargaining power of suppliers. Indeed, it remains to be seen if HeartWare can take market share away from its larger rival, Thoratec.

Outside of near-term challenges, the company appears to have bright growth prospects for the future. It is currently developing its HeartMate III device, which should be available late next year. The technology will attempt to reduce the frequency of adverse events like thrombosis, stroke, and aortic insufficiency. Japan also presents a growth opportunity, as a number of surgeon’s there expect the current annual implant rate of 50 units to jump to 200-300 in a matter of years. This will require good clinical trial outcomes and more physicians accepting long-term support as a method of treatment instead of strictly doing transplants, the number of which are currently small in Japan due to limited availablity of donor hearts.

Overall, we expect Thoratec to continue generating healthy cash flows for the foreseeable future. Still, increased competition may discourage conservative investors from jumping in until visibility into the competitive landscape improves.

Company

Ticker

Industry Name

CryoLife Inc.

CRY

Med Supp Invasive

Cyberonics

CYBX

Med Supp Invasive

Thoratec Corp.

THOR

Med Supp Invasive

Varian Medical Sys.

VAR

Med Supp Invasive

Hologic, Inc.

HOLX

Med Supp Non-Invasive

Masimo Corp.

MASI

Med Supp Non-Invasive

Schein (Henry)

HSIC

Med Supp Non-Invasive

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.